NVCA Today

Written by Taylor L. Stevens¹

The economic downturn has contributed to a dramatic slowdown in exit opportunities for venture capital-backed companies. The growing number of later-stage companies, many of which may have been ripe for an acquisition or public offering in more favorable market conditions, has forced a shift in the stage of investment focus among many venture capitalists. Investors now face difficult decisions regarding which portfolio companies will continue to receive funding through extended lifecycles.

Not all investors are able or willing to continue to risk additional capital during challenging economic conditions. Those that are, however, may expect the other investors in the syndicate to share in that risk. Increasing concerns over future funding participation by existing investors have led to a renewed focus on pay-to-play provisions for many venture capitalists. Against this backdrop, and amidst current market conditions, it is prudent for investors to understand the mechanics of pay-to-play provisions and the scope of available protections against such techniques.

What is a pay-to-play provision?

Pay-to-play provisions are designed to encourage the participation of existing investors in a subsequent financing round. Investors that fail to participate to their full pro-rata percentage of the financing are penalized by losing certain rights with respect to their existing preferred stock. Commentators and venture investors alike have offered various justifications for the pay-to-play structure. Proponents assert the mechanism benefits both the company and the investor syndicate by aligning expectations at the outset of the transaction and incentivizing all investors to continue to support the company, especially during challenging times when an incentive is most needed. Advocates further contend that absent pay-to-play provisions, those investors who do not participate in the next financing and who continue to hold a preferential security will receive a free ride on the support of the participating investors. Pay-to-play provisions are designed to eliminate this free-rider dilemma and further ensure that every investor will pay in one way or another. If existing investors who are subject to pay-to-play provisions elect not to fund the required investment amount in a subsequent round, they will ultimately pay by forfeiting all or a portion of their existing rights.

Investors that are unable to recover capital from prior investments during difficult economic times may insist that new capital be given the greatest opportunity to generate high returns by reducing, or eliminating, potential payments to the prior investors. In this regard, pay-to-play provisions can serve as a double-edged sword for some investors. Those that encourage pay-to-play provisions as new investors in one company may simultaneously seek to avoid similar provisions as existing investors in another company.

How are pay-to-play provisions structured?

There are a variety of ways in which pay-to-play provisions can be structured. Typically, the funding obligation of an investor subject to a pay-to-play provision is triggered by the closing of the company's next equity financing. In other variations, an investor's funding obligation may be conditioned upon the company's achievement of certain operational or financial milestones. Alternatively, an investor may have no obligation to invest in a subsequent financing unless the company first raises a target investment amount from an outside investor within a specified number of months following the closing of the prior financing.

Once the funding obligation is triggered, the pay-to-play mechanics commonly provide that a non-participating investor's preferred stock will be automatically converted into a new series of preferred stock, referred to as "shadow preferred." The shadow preferred is identical in all respects to the original series of preferred stock held by the non-participating investor, except that it may lack one or more of the following preferential features: (1) participation rights in future company financings, (2) voting rights with respect to certain company actions, (3) price-based antidilution protection (alternatively, it may provide for antidilution protection that is less favorable than that afforded to participating investors), (4) all or a portion of the liquidation preference, or (5) other preferences, including the right to designate board seats or receive certain company financial information. A more draconian version of the pay-to-play provision provides that non-participating investors will have all of their existing preferred stock automatically converted into common stock, resulting in the complete loss of all preferential rights. In most situations, pay-to-play provisions can significantly impair the value of the prior investment by reducing the liquidation preference, diluting the ownership position, or eviscerating other preferential rights of non-participating investors.

How are pay-to-play provisions implemented?

Pay-to-play provisions are typically implemented during economic downturns when investment capital is more difficult to obtain, and a built-in incentive structure for all investors to continue to support the company is most needed. The pay-to-play mechanics may be written into the company's charter in anticipation of future financings. In such circumstances, the existing investors collectively define a roadmap as it relates to their respective investment obligations in connection with the company's subsequent financings.

The absence of pay-to-play provisions in a company's charter, however, should not provide meaningful comfort to existing investors that the company's next financing will be free from pay-to-play features. Investors frequently invoke pay-to-play variants retroactively when presenting an ultimatum to other existing investors who decline to participate in a current financing round. In traditional pay-to-play structures, the participating investors may elect to amend the company's existing charter prior to the closing of the current round in order to integrate those provisions necessary to effectuate the desired penalty for non-participating investors.

Participating investors may also seek to implement a variation of the traditional pay-to-play structure referred to as a "pull-up." Pull-ups provide participation incentives by enabling investors to pull forward existing shares of company capital stock (that are typically buried beneath a stack of senior liquidation preferences) into a newly issued preferred series with superior rights to the existing preferred stock. While pull-ups are largely designed to encourage continued participation based on the "carrot" rather than the "stick," this variation may be combined with other recapitalization features to implement a more traditional and punitive pay-to-play structure.

The pull-up mechanics are typically written into the purchase agreement entered into by the company and the participating investors in the current financing. As such, in contrast to traditional pay-to-play provisions, pull-ups are commonly "contractual" exchanges that take place outside of the scope of the company's charter.

What protections are available to existing investors?

Applicable corporate statutes offer existing investors some protections against pay-to-play variations proposed in connection with future financings. For example, a proposed amendment to a Delaware company's charter to directly strip preferential rights from an existing preferred series will require a majority vote of the affected series under Section 242(b)(2) of the Delaware General Corporation Law. It is important to note, however, that the class vote protections offered by Section 242(b)(2) do not apply to "indirect" adverse effects resulting from an enhancement in the preferences of another series. Hence, the creation of a new senior preferred series will not by itself implicate the class vote protection under Section 242(b)(2).

Due to limitations in certain statutory frameworks, an investor's best protection against impending pay-to-play variations may be provided by the "protective provisions" set forth in the company's charter. These protective provisions establish limitations on the company's power to take certain actions without first obtaining the consent of specified stockholders or groups of stockholders. Common provisions requiring such approval include (1) changing the preferences of existing preferred shares to adversely effect such shares, (2) authorizing shares with preferences superior to existing preferred shares, (3) reclassifying existing preferred shares, and (4) other corporate actions such as mergers and consolidations, dividend payments, capital stock redemptions, and increases in the size of the board of directors.

Well drafted charter-based provisions can offer protection to investors by minimizing the risk of financing variations that may diminish or eliminate the preferential rights of existing investors. It is critically important, however, for investors to ensure that the protective provisions are carefully constructed, and sufficiently broad, so as to avoid unintended loopholes. For example, "no adverse amendment" provisions may not be sufficiently broad to protect against the creation of senior securities. Similarly, class vote requirements for the "authorization and issuance of senior securities" may inadvertently fail to protect against the creation of junior series with "equal" liquidation preferences. Additionally, class vote requirements to "amend the company's charter to reclassify shares of existing preferred" will be ineffective against contractual pull-up structures that are not implemented through an amendment to the company's charter.

Delaware Chancery Court rulings such as Benchmark Capital Partners IV, L.P. v. Vague underscore the importance of having clear and precise language in charter-based protective provisions. In Benchmark, the court ruled that the use of a merger with a wholly-owned subsidiary to effect substantial changes to the rights of the existing preferred stock was permissible because the protective provisions failed to specifically preclude company actions by "merger, consolidation or otherwise." The Benchmark decision reaffirms that preferential rights will not be "presumed or implied" and that all rights, preferences, and limits of the preferred stock must be "expressly and clearly" stated in the charter.

It is also important for existing investors to consider and protect against certain investor-initiated actions. For example, a class vote requirement on the company's ability to recapitalize shares of existing preferred stock will not protect against an investor-initiated action to convert all outstanding preferred stock into common stock pursuant to the conversion provisions of the charter. Inconsistencies between the consent requirements for company-initiated actions and investor-initiated actions can result in unintended loopholes that may be utilized to strip preferential rights of existing investors.

What is the takeaway?

Subtleties in corporate statutes and drafting nuances in charter-based provisions may surprise the unwary by giving rise to unanticipated financing alternatives that can erode the economic value of an original investment. Even savvy investors with robust protective provisions may still be unable to prevent "all" financing alternatives that could affect existing preferential rights. An investor's ability to effectively block a pay-to-play variation will depend not only on the breadth of the available protections, but also on whether such investor (either individually or collectively with other like-minded investors) holds the requisite votes to veto the proposed transaction pursuant to the terms of the charter-based protective provisions or applicable state statutes.

While investor interests are typically aligned at the outset of the initial investment, dissension over company prospects or financing alternatives may cause such interests to diverge over time. The result is that minority investors may be left exposed and unable to block an impending pay-to-play transaction. Although fiduciary duties of the board of directors and majority stockholders will establish some parameters on the structures and procedures for a proposed transaction, having a strong command of the protective landscape in advance of a subsequent financing (including the strengths and weaknesses of such protections) will better position existing investors to effectively assess and respond to proposed pay-to-play variations.

¹Taylor L. Stevens is a partner in the San Diego office of Morrison & Foerster LLP. He is a member of Morrison & Foerster's Emerging Company and Venture Capital Group and can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .